Real Estate in China: the Good, the Bad and the Ugly

What ails real estate in China? Are we heading for a property market crash? Does the government need to step in and save the day? In this wide-ranging interview, CKGSB professor Liu Jing, an expert on the real estate market, analyzes the situation in China’s real estate sector.

China bears have never been this close to successfully predicting a housing crash. Home prices in major Chinese cities are slipping, and transactions are taking a nosedive. The real estate market has entered what is arguably the deepest correction since the 2008 financial crisis, causing fears of a hard landing that might also drag down the entire Chinese economy.

So how much trouble is real estate in China really in? According to the China Index Academy, a property research organization owned by of real estate portal SouFun, housing prices in the 100 cities it monitors dropped 0.5% in June 2014 from a month earlier, greater than the 0.32% month-on-month decline recorded in May, which was the first price downturn in 23 months.

But falling prices is not the most alarming signal, at least not yet. It’s the distinct drop in transaction volume that is making economists uncomfortable. Transactions across major cities fell 19% year-on-year in the first six months of 2014, SouFun’s data shows, while new home transactions in Beijing and Shanghai dipped 48.6% and 32.8% respectively, according to other research firms.

Analysts attribute the anemic demand to a credit squeeze and expectations of downward prices. While the trend is widely expected to last through the rest of the year, the million-dollar question is: how soon will the situation change? Will developers, whose inventory levels are near a four-year high, lower prices to sell out? Or will authorities in Beijing, who haven’t turned to any major stimulus measures, finally decide to bite the bullet?

We took those questions to Liu Jing, Professor of Accounting and Finance at CKGSB and an expert on China’s real estate market. In this interview, Liu sheds lights on where the current crisis comes from and why it is tied to the structural changes of the Chinese economy.

Q. Some people say the shadow banking crackdown is the key reason behind the credit crisis many developers are facing right now. But are there more fundamental causes to their financial problems?

A. What we are seeing in the property market today is predictable. In the short-term, the government’s crackdown on financing for the real estate sector, and on housing purchasing restrictions definitely have effects. But they are small and temporary. The larger factor is the economy itself. Even without the government crackdown, the market should be exhibiting some features like what we are seeing today. The speculative demand eventually will dry up because the economy cannot be driven by speculation. In general, the economy is slowing down, and that has a big [impact on] people’s psychology in terms of their expectations about the future performance of housing prices.

In a sense, it is very similar to 2008 and 2009, when the financial crisis hit. If you look at the transaction volume during the financial crisis, it actually dried up. A lot of people wanted to sell but they couldn’t. The global financial crisis affected how people viewed the market. As a result, liquidity dried up and prices came down. It actually was the government’s stimulus that [pushed] prices back up.

Q. Will housing prices bounce back quickly this time too?

A. No, I don’t think so. The prices bounced back right away last time because of two reasons. One is that the government put in a huge stimulus package—RMB 4 trillion. The actual amount could be way more than that if you count local governments’ borrowings. The second was because the government exerted so much effort to rescue the market so people’s belief changed. People believed that the government can drag the economy out of the… the financial crisis. But I think this time it is different. We [have a] consensus that the old Chinese economic structure has to be changed. As a result, we are not going to see a large bailout as last time.

Everybody is talking about moving towards more consumption—that was the direction, but we don’t know how to move towards that direction. There are a lot of implementation issues. There is a lot of uncertainty about whether that switch is going to make the economic model successful. I think this time the threat to housing prices is much more severe. It finally hit the Chinese investors that real estate [prices are] not something that go up day after day, year after year.

Q. Do you think developers will drop prices of new homes voluntarily?

A. They would like to. A lot of developers are thinking of dropping prices if they could. But the problem of being a property developer in China is that they often face a lot of resistance from existing homeowners. People who already purchased their houses don’t want to see prices drop. They ‘hijacked’ the developers and said, “You are not supposed to drop prices.”

In the last four to five years, developers became too optimistic. Many of them borrowed heavily and invested heavily. They bought very large pieces of land at prices that are inflated. They are under stress and they have to sell their inventory in order to recover the money. But they can’t. Some of them are hoping that the market will recover so they can recoup.

Q. It’s interesting that you mentioned this. There was a news story that said that some homeowners blocked the entrance to their gated residential area to prevent potential buyers from going in because the developer lowered prices. Do home owners have that much influence on developers?

A. Yes, they do. I talked to several developers and they all face this problem. They can’t lower prices because of the pressure from homeowners. They are worried that the existing owners will cause a lot of trouble…in the form of demonstrations. Then the local government will come to the developers and say, “Don’t drop prices.” They are really faced with a lot of pressure not to deviate from the general norm.

So the developers are trying to come up with a scheme like “shadow discounting”. For example, they can give away free stuff, like free interior decorations or return money to the buyers some years down the line. From their point of view, it’s in their best interest to cut prices.

Q. In terms of government policies, do you think Beijing should step in to ease purchasing restrictions? What do you think Beijing should do?

A. I think there is not much more that can be done. If you want to support the prices, you basically are supporting an asset bubble. That’s going to have effect on the whole economy. But in the last few years, we’ve already raised the leverage for a significant amount in order to get out of the financial crisis. [Injecting another large-scale stimulus] is contradictory to the idea that the Chinese economic structure needs to be changed.

Q. What about local governments? They are still under immense pressure to meet GDP targets. Would they loosen policies?

A. Yes, you’ll see a lot of local governments ease the purchasing restrictions but those would not have too much effect. People’s psychology has been changed. People do see the uncertainty in the economy; people do see that the growth rate is dropping. Local governments don’t have resources to bail out these real estate companies. [Legally] they cannot issue debts so they probably will have to borrow through those government-owned entities. But the amount [that they could raise] is limited because the central government is paying attention to this [form of shadow-banking practice].

Liu Jing explains why the current housing downturn
is different from before (video by Major Tian)

A. If you look at China’s per capita living space, the number is like 35 square meters: 35 is not terribly high. If Chinese people want to improve their living conditions, they are going to need more housing. But given today’s income level, housing prices are too high. It’s hard to believe that the market can absorb so much supply at such high prices.

Q. Some of the biggest players like Vanke have a lot of cash in hand. Will there be more M&As in the sector?

A. This depends on how prices go. In the beginning, it’s not a good idea for these larger developers to buy out the smaller ones if prices are going to stagnate or decrease over a few years,. It’s a much smarter idea to wait until these [smaller] companies die. If they die and release the land, then the developers can buy at much lower prices.

For example, Greentown [a developer based in Hangzhou] got into trouble because they invested too much in 2009 and 2010. Then the government’s restrictions tightened and they faced a severe problem in terms of [high] leverage. They started to sell their projects to Soho China, or Fosun. They then figured that selling projects was not solving their problem, so they sold a large chuck of equity to other real estate companies.

In the US, in the beginning of the financial crisis, there were very few transactions. But later on when things were stabilized, some firms were already bankrupt. Then some of the large firms started buying them. So I would say in the immediate future you are not going to see too much [M&A] in China’s housing sector.

Q. How big is the impact of real estate on the Chinese economy?

A. It is very large. It depends on how you measure it. Some people say it is some 16% to 17% of the GDP. There is another effect, which is not directly related to real estate—the wealth effect. If you count the number of houses and then multiply that by the market prices, Chinese housing market is very large. I did a simple calculation and it is like three to four times of China’s GDP. If the prices drop by 10%, that’s a huge wealth reduction. As a result, a lot of people might reduce their consumption. That’s the real danger.

A. [Enforcing property tax] is difficult because you are changing the financing methods of local governments. They currently don’t collect property tax, so they get lots of financing from selling land and that’s why local governments actively participated in the price boom of the housing market.

But in the long run, implementing such tax is definitely the way to go. Hong Kong has a similar situation, where the government sells land to get financing but the tax rate is very low. So look at housing prices in Hong Kong—they are among the highest in the world. That definitely reduces the welfare of its citizens.

Q. So what’s your view on the sector for the longer term?

A. For real estate companies, the next four to five years will be very tough. My personal view is that the situation of high returns on real estate investment is gone. The housing growth during 2000 to 2010 was abnormal—we ate our future lunch.

The analogy would be the US market. It took several years for the US to get out of the sub-prime mortgage trouble. But I would argue that even today, the US market still has problems—housing picked up but still under the effect of very low interest rates. There is a huge amount of liquidity floating around to support the prices. If China gets into that situation, it would be a huge headache.

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Information, analysis, and interviews about the Chinese economy and doing business in China, from the people who know it best. Presented by the Cheung Kong Graduate School of Business, China's leading business school.